Dow Jones Industrial Average, S&P 500 Post Biggest Losses of Year

Traders work on the floor at the New York Stock Exchange, June 20, 2013.

Brendan McDermid/Reuters

Stocks endured their worst two-day sell-off this year as investors reacted to Federal Reserve Chairman Ben Bernanke's comments about scaling back economic stimulus later this year.

For most people, the sell-off seems odd. After all, the Fed chairman is going to ease back on stimulating the economy through bond purchases because it's doing well enough that the juice is not needed. But the end of cheap money and a rise in interest rates is seen as a negative for stocks.

At the close of New York trading on Thursday, the Dow Jones Industrial average fell 2.3 percent, or 354 points, to 14,758. The S&P 500 fell 2.5 percent to 1,588 and the Nasdaq Composite dropped 2.3 percent to 3,365.

The price of gold fell 7 percent to $1,278, falling below $1,300 an ounce for the first time since Sept. 2010. Silver fell 9 percent to below $20 on Thursday, the first time below that level since Sept. 2010.

Robert Johnson, director of economic analysis with Morningstar, said while the Federal Reserve was the primary market mover yesterday, reduced growth expectations, a slower manufacturing sector and lending conditions in China are also contributing to the decline today.

"Worries about even higher rates are misplaced. The economy can easily survive higher rates, and given some recent slowing rate increases could pause shortly. Higher rates are not an entirely bad thing for the economy," Johnson said, such as higher retiree incomes, and people moving to action by the threat of higher rates.

Bernanke said that the Fed may begin to pull back its $85 billion a month bond purchasing program as early as this fall if the economy continues to improve through the end of the year, adding that the unemployment rate will likely be 7 percent when the Fed begins to draw down its stimulus.

The agency said it will keep interest rates low until the unemployment rate is below 6.5 percent. The Fed lowered its unemployment forecasts for this year to 7.25 percent, slightly better than its previous projection of up to 7.5 percent. Its forecast for the unemployment rate next year is 6.65 percent.

The Federal Reserve has injected trillions of dollars into the slowly recovering American economy. After its two-day meeting, the Federal Reserve's Open Market Committee decided to keep the target rate for the federal funds rate at zero to 1/4 percent. Between the next year or two years, inflation is projected to be more than a half percentage point above the committee's two percent long-term goal, the Fed said.

The Federal Reserve is one of the biggest buyers of Treasury notes right now, and their policies not only affect demand for bonds, but also inflation.

The uncertainty over inflation and interest rates has led to caution in financial markets.

Guy LeBas, chief fixed income strategist for Janney Capital Markets, said the size of the selloff of Treasury bonds following Bernanke's press conference on Wednesday afternoon has taken most market participants by surprise.

"When we dissect the move over the last two days and last two months, all of it has come despite falling market inflation expectations," LeBas said. "That suggests that technical factors rather than fundamentals are behind the move in [Treasury] yields."

Stock investors are worried that an end to the stimulus program will mean a swoon in equity prices. Bond investors fear that higher interest rates will depress the value of their holdings. When interest rates go up, the value of bonds declines.

LeBas said the 2.40 percent yield on the 10-year note, up about 1 percent from 18 months ago, makes it more attractive, in after-inflation terms, than at any point since 2011.

Johnson said the 10-year Treasury rate probably belongs closer to 3 to 3.5 percent based on current inflation rates.

"Even 3.5 percent interest rates would not be enough to kill the recovery," Johnson said.